Pages

Wednesday, January 28, 2015

The Stock-Picker’s Checklist

I was a stock-picker for about 12 years. In the early years my habits were very effective for protecting my ego and maintaining my confidence. However, as time passed I began to slip. Reality invaded my thoughts. I was no longer blind to my real skill level. Eventually, I couldn’t pick stocks any more. I’ve turned my cautionary tale into a checklist for those who want to feel good about their stock picking.

1. Don’t calculate your returns.

In my first few years of stock picking, I never calculated my return on any stock investment. I just had the vague warm feeling that I’d made some good picks. This was helped greatly by some extremely good early luck in 1998 and 1999.

2. If you must calculate returns, do it separately for each stock.

When I first made the mistake of examining my returns, I looked at each stock separately. I also managed to not calculate the returns for picks that worked out badly. This had the advantage of allowing me to focus on my wins and not think about the losses. I felt great about my abilities.

3. If you must calculate portfolio returns, exclude anomalies.

When I started to calculate overall portfolio returns, I didn’t quite include all the stocks my wife and I picked. I tended to group only a subset of my accounts together. The fact that our worst picks were in the accounts I excluded was just a coincidence. It’s amazing how great your results look when you drop out a couple of real stinkers.

4. If you must calculate complete portfolio returns, shop for a good time period.

As I began using spreadsheets to calculate overall portfolio returns, it became more difficult to justify excluding a few bad results. But it was easy to choose a favourable time period. Because my initial results were so strong, I always looked at my total returns from the beginning. This way, a few recent bad results still left me with good overall returns. This method of always starting the clock before a period of strong returns is very helpful for the ego.

5. If you must calculate annual complete portfolio returns, don’t compare them to benchmarks.

As I began computing my annual portfolio returns, it became harder to ignore poor years. But I found solace in knowing that things could have been worse. There were stocks I passed on that would have made my annual return even lower. At least I was doing better than some of my friends who picked some real dogs.

6. If you must compare your annual returns to a benchmark, shop for a low benchmark.

It’s amazing how much flexibility there can be in choosing a benchmark. If you own stocks in Canada and the U.S., you can use just an index of Canadian stocks, or you can use a blend of Canadian and U.S. indexes. There are a number of U.S. stock indexes to choose from, and you can choose whether to factor in currency exchange rates or not. By choosing the method that gives the lowest benchmark return and rationalizing why this method makes sense for the current year, you can make your own results look good. The key is to choose your benchmark at the end of the year rather than in advance.

7. If you must compare your annual returns to an appropriate benchmark chosen in advance, just give up stock picking and invest in broad indexes.

When I finally removed the last remaining wiggle room from comparing my returns to a sensible benchmark, I had to face my poor investing record from the year 2000 on. I’ve been steadily shifting to investing in low-cost broad index ETFs since about 2010. The process is nearly complete today.

No doubt readers have figured out by now that I’m not serious about this advice. I don’t advocate deluding yourself into feeling good about failed attempts to beat the market through stock picking. If you’re one of the extremely rare people who actually compare your annual returns to an appropriate benchmark chosen in advance, and you show positive alpha over many years, then good for you. However, others should seriously consider giving up stock picking.

14 comments:

One argument that I notice is from folks who dumped their advisor after the 2008 crash to become a DIY stock picker and now proclaim that their portfolio is doing much better than ever before, while completely ignoring the fortunate timing of entering a five-year bull market.

@Robb: I hear this from people who switched advisors as well. Unfortunately, they tend to look at absolute returns. For all they know, their previous advisor was beating the market during the tough times and their new advisor is lagging the bull market badly. People like this are almost certain to change advisors again during the next bear market.

Good that you made a choice appropriate to your emotional makeup. Investing isn't an easy skill to master. Your essay reminds me of this clip from an interview with Buffett and Munger about 5 years ago:

Munger: We’ve learned how to outsmart people who are clearly smarter [than we are.]

Buffett: Temperament is more important than IQ. You need reasonable intelligence, but you absolutely have to have the right temperament. Otherwise, something will snap you.

Munger: The other big secret is that we’re good at lifelong learning. Warren is better in his 70s and 80s, in many ways, that he was when he was younger. If you keep learning all the time, you have a wonderful advantage.

@Anonymous: I think you misunderstand both my comments and those of Buffett and Munger. Buffett and Munger's remarks about temperament apply to any style of investing including index investing and stock picking. Choosing between index investing and stock picking should be decided based on skill (unless you don't care about money). The only way to measure skill in stock picking is to make comparisons to a reasonable benchmark. My choice of passive investing has little to do with my "emotional makeup," although you could argue that my ability to measure my returns against benchmarks fairly is only possible due to an ability to think rationally.

I've got one more. Always double down on your losing stocks. That way your 20% loss only looks like a 10% loss. Plus it’s easy to rationalize as buying low/being a contrarian/buying when there’s blood in the streets.

Interesting post - seems very applicable to those who start out stock picking to move to indexing. I started as indexer and over time migrated to stock picker..... oops. Nothing wrong with indexing - but for me (withdrawal stage) lower costs for (dividend growth) income win out. In Canada with the unbalanced nature of the market (Heavy in resource/financial) I do not think it is unrealistic to achieve some small alpha. for US/International that is a much harder task. I have used FPX (Growth) benchmark which is primarily Canadian and have achieved a small alpha over 3/5/10 years

@Anonymous: According to what I found online, FPX Growth contains 10% T-bills, 20% medium term bonds, and 70% stocks (a mix of indexes). This would not be an appropriate benchmark for a dividend stock portfolio. The cash, bonds, and lack of value tilt throw off the comparison.

My portfolio is now 67% stock 33% FI (It was 3 years ago 75%/25% when I was still earning and accumulating). It is difficult to find a benchmark to use and stick to for long times (decades) as goals and asset allocations change.